My not-so-profound thoughts about valuation, corporate finance and the news of the day!

Monday, March 24, 2014

The impossible quest for fair markets: Pokemon cards, HFT and Life lessons

In my last post, I looked at the Insider Trading 2.0 doctrine advanced by Eric Schneiderman, the Attorney General for New York, and argued that is was overly broad and likely to create more harm than good for small traders/investors, the very group that he wants to help. Mr. Schneiderman is drawing on what we all accept is a laudable goal, which is the search for fairness. It is, however, an impossible mission and I will use a personal story to bring it home.

The parental dilemma
My children are all grown up now, but when one of my sons was five years old, the Pokemon trading frenzy was in full force, and as a neighborhood with more than a dozen young children, we were exposed. For much of the summer, the trading volume in Pokemon cards was high, as children, most of whom could barely read, traded Pokemon cards with each other, with emotion, impulse and that morning's Pokemon episode on TV driving trades. Sometime in late June, my son came home crestfallen, after a day of trading disappointments, full of complaints about market unfairness. A six-year old (who I will call HFT to disguise his identity) had entered the Pokemon market with two powerful advantages: he could read relatively well and he had a Pokemon trading card book, which he had used to "exploit" the rest of the market.

Choices and Consequences
If Mr. Schneiderman had lived in my neighborhood, he would undoubtedly have come with regulations on trading that would have protected the weaker traders, either by requiring passing a reading test to trade in the market (which would have left the six year old as the only trader in the market, and killed it) or failing that reading test as a prerequisite, which would have led to cheating and/or a black market in Pokemon cards. I am afraid that I did not have the legal authority over my neighborhood to concoct a version of Pokemon Cards 2.0, and my son and I, after some discussion, came up with four options:

If you cannot beat them, join them: I suggested that he spend the rest of the summer, learning how to read better and promised that I would buy him the Pokemon trading book as a reward, an option he quickly and rightfully rejected as a summer-vacation killer.

Reorient your trading: I noted that he could be selective about his trading partners, avoiding the well-read six year old at all cost and looking for other children in the neighborhood who could read less than he (my son) as trading partners. I offered this laws-of-the-jungle choice reluctantly, and I was relieved when my son, after thinking about it for a few minutes, decided that he could not take advantage of babes in the market (literally speaking).

Become an intermediary: He could quit trading and become an intermediary in the market, charging a commission (Nickels, candy etc.) for bring buyers and sellers together, but after giving this some consideration, my son demurred, noting that his role would then be finding suckers for HFT to take advantage of.

Leave the market: My son came up with the fourth choice himself, which was to recognize the reality that he could not win in this market and that the most prudent decision to take was to exit the market, which he did by liquidating his card inventory the next day.

There is a happy ending to this story. That summer, HFT cornered the market and acquired the best Pokemon card collection in town, at bargain prices. By the next summer, though, his advantage dissipated, because there were at least three other kids in the neighborhood who could read, with their own Pokemon guidebooks. The game became more of a "loser's game", as HFT found himself trading almost as frequently with traders who were as informed as he was, or better. He also made the mistake that many successful traders make of ignoring the fundamentals, which with collectibles is simple: the price is inversely related to the supply and if the supply is unchecked the price will go towards zero. I must admit that I was secretly happy when I saw HFT's entire card collection up for grabs for a couple of dollars at a garage sale a few years later.

Trading in an HFT World
There is a larger debate that is worth having about high frequency trading that has nothing to do with insider trading. It has changed the trading game, putting small traders at a disadvantage. My father-in-law was a day trader in the 1970s, a time when information was transmitted in phone calls with brokers and trades were on the floor of the exchange. Information reached markets in a leisurely fashion and he was able to make his share of the profits. He was already a dinosaur by the 1990, when a new generation of traders used computers to both access information and trade on it, as the reaction time went from hours to minutes. Now those traders are being threatened by more powerful computers, as reaction times go from minutes to milliseconds. Like my son, I think that if you are a trader, you have four choices.

Invest in technology: You can try to compete with the HFT traders, paying for information and the latest trading technology, setting into process a game of mutually assured profit destruction. For most smaller traders, the investment is too steep to even consider this option.

Change your trading game: You can adapt your trading strategies to increase the likelihood that you are trading against those who are less informed (or more emotional) than you are and decrease the chances that you are trading against those who have an advantage over you. In particular, you can shift your trading from the periods when information is released (which is the moment when HFT has its maximum advantage) to the aftermath of the announcements. There is often as much money to be made in the price drifts after news releases as in the immediate reactions, and computerized trading has little or no advantage at this stage of the pricing game.

Become intermediaries who supply liquidity rather than trade on information, and it is a fact that even within the HFT community, there are some who have chosen this route, as the business becomes more competitive and less profitable.

Become an investor: You can stop playing the pricing game, i.e., being a trader, and play the value game, I.e., become an investor. As an investor, you are unaffected by computerized or high frequency trading, and at the margin, may even be helped by it. HFT trading takes the worst aspects of trading, following the crowd and the neglect of fundamentals, and magnifies them, driving price away from value in both directions. Like the neighborhood kid collecting Pokemon cards discovered years ago, fundamentals matter, and these big traders will face their day of reckoning, sooner than you think.

18 comments:

Anonymous
said...

I think for small investors even becoming 'investors' also is rather difficult because they lack knowledge about finance and business valuation.

They follow what someone else (friend, relative, broker, analyst, or anyone) tells them. They also become greedy and put money. Whose fault is this? - legally not the advisers (morally may be). They have to blame themselves.

There is another option that can be given to them - Learn the game or don't play it. One doesn't have to attend b-schools to educate oneself on the art of finance, business and stock picking.

The best way regulators can protect small investors is by telling them this hard truth.

If insider trading is allowed to exsist the whole basis of fairness in the market place goes out the window. When a few select insiders can know ahead of time what the news on a company will be than its really just like Stealing. If I know ahead of time who will win the superbowl or who will win the world series than any one else placing a bet would just be gambling except those that know for certain what the outcome will be.